Since the Tax Cuts and Jobs Act of 2017 (TCJA) was passed, many business and professional services firms have begun to analyze the new law to determine how it may impact their businesses, their partners and their shareholders. The change in the corporate tax rate (reduced to 21 percent), combined with the 199A deduction available to some pass-through entities, has led many business and professional services firms to re-examine their current tax structure. In addition to the broader questions related to choice of entity, firms must also consider how key changes to the tax code affect their businesses, partners and employees.
Meals and entertainment
Under prior law, a taxpayer could only deduct 50 percent of meals and entertainment expenses unless certain exceptions applied. The definitions of meals and entertainment were intentionally broad, and there were numerous exceptions that caused certain meals and entertainment (M&E) expenses to be 100 percent deductible. However, the TCJA has limited the deductibility of some of these costs. For example, the TCJA completely eliminates the employer tax deduction for substantially all directly paid or reimbursed business entertainment expenses. Furthermore, the TCJA limits the deductibility of the costs of food and beverages provided to employees through an eating facility, as well as other employer-provided de minimis food and beverages at the workplace (such as coffee and donuts, working meals and overtime meals) unless they are served as part of an event that would fall under the employee recreation exception of section 274(e)(4).
Companies should review the tax treatment of their M&E expenses to identify expenses that should be 100 percent deductible, those that are 50 percent deductible and those that are now completely nondeductible. Business and professional services firms will most likely need to make changes to their systems and processes and could benefit from a meals and entertainment study to maximize their deductions.
Transportation fringe benefits
Many business and professional services firms provide employees with parking and other transportation fringe benefits that previously have not been included in the employee’s gross income despite being fully deductible for the employer. The TCJA has eliminated the deduction for qualified transportation expenses (including parking) unless the amounts are included in the gross income of the employee. Firms must decide if they will forego the deduction (thereby increasing owners’ pass-through income), or if instead they will pass the tax burden to their employees by including the amount in taxable wages. These are important decisions as firms may utilize fringe benefits to attract and retain top talent.
Family and medical leave credit
There are some new credits available to businesses, such as the paid family and medical leave credit. This temporary credit is outlined in section 45S. The provision enables eligible employers to claim a general business credit equal to 12.5 percent of the wages paid to qualifying employees during any period in which such employees are on family and medical leave, provided the rate of payment under the program is at least 50 percent of the wages normally paid to an employee. The credit is increased by 0.25 percentage points (but not above 25 percent) for each percentage point by which the rate of payment exceeds 50 percent. The maximum amount of family and medical leave that may be taken into account with respect to any employee for any taxable year is 12 weeks.
Choice of entity
With the reduced corporate tax rate (now 21 percent) and the new 20 percent pass-through deduction, many business and professional service firms may ask if now is the time to consider changing their entity structure. However, there are many factors to consider. First, firms in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services and brokerage services are generally not eligible for the new 20 percent pass-through deduction. The deduction is also denied to any business whose principal asset, “is the reputation or skill of one or more of its employees or owners.” Fortunately, on August 8, 2018, the IRS issued proposed regulations, which limited this provision to a trade or business where a business receives fees, compensation or other income for endorsing products or services, licensing their likeness, image or other associated symbols or appearing at events or on television, radio or other media. By narrowly defining this provision, more business and professional services companies, not in the prohibited fields, should qualify for the deduction, if they meet the additional tests and qualifications.
Firms that do not qualify for the pass-through deduction may be enticed to consider converting to C corporation status to take advantage of the lower corporate rate; however, this analysis can be complex and there are many factors to consider. For example, many professional services firms distribute most of their earnings, which as a C corporation would trigger a second layer of tax. These alternatives should be reviewed and careful consideration given to various impacts.
Unfortunately, the proposed regulations also contained anti-abuse rules that will prevent pass-through businesses from “cracking and packing” their business activities in an effort to maximize the 20 percent pass-through deduction. “Crack and pack” planning would entail either splitting commonly controlled trade or business into multiple businesses or combining separate businesses into one. Doing so might have permitted companies that would otherwise be prohibited from taking the pass-through deduction to carve out qualifying business income to generate a deduction. For example, a law firm that owns its building may have considered moving the building into a separate entity in order to take the pass-through deduction on the rental income paid to the related entity. Per the proposed regulations, a trade or business that provides 80 percent or more of its property or services to a commonly controlled (50 percent or more common ownership) prohibited trade or business will also be considered a prohibited trade or business. If less than 80 percent of its property or services are provided to the commonly controlled entity, the portion of the services provided to that business will not qualify for the deduction.
Firms that believe they will qualify for the pass-through deduction must also consider many factors when reviewing their entity structure. There are limits on the deduction based on W-2 wages and fixed assets. Computations should be performed to determine if the deduction may be limited. Firms must also consider the tax implications of a conversion to or from a corporation to determine if there are any unintended tax consequences of a conversion, including estate and wealth transfer planning. Business and professional services firms should work with a qualified tax professional to perform a full analysis of potential conversion consequences; there are many complex factors that could impact the analysis.
U.S. business and professional services firms that operate abroad should review their structure to determine the potential implications of several international provisions in the TCJA, such as Global Intangible Low Taxed Income (GILTI). There may be traps for the unwary, and a structure review could help achieve tax efficiency and identify potential exposure.
Conversely, foreign business and professional services firms may have partners that have effectively connected U.S. income and therefore have a filing responsibility in the United States. It is important to work with a tax advisor who can help develop a coordinated approach to U.S. and local country tax laws by employing an international partnership.
Business and professional services firms face several challenges as a result of the TCJA, but there are also opportunities to maximize the benefit under the current law by reviewing M&E, fringe benefits, structure issues and credits. Firm partners and shareholders should be reviewing their personal tax structure to maximize tax efficiencies.